I talked with two clients last week about their home equity lines of credit (HELOCs). These can be very helpful forms for available debt to have in place so I thought it was worth discussing in more detail

What is a home equity line?

A home equity line of credit (or a HELOC as it is also known) is a revolving line of credit that is secured by the equity you’ve built in your home. If you have a first mortgage in place, the HELOC will act as a secondary mortgage on your property.

How does a HELOC work and why/when would I use it?

A HELOC is an available line of credit – not a loan. Meaning, when you apply, you are granted an available amount of credit. However, you do not need to draw on it at that time (or ever). By having a HELOC in place, you can have nearly instant access to liquidity when you need it most, such as for a urgent home repair or to fund day to day living costs if you have a sudden loss of income. In other cases, it can be advantageous to use a HELOC to fund other planned costs such as a home remodel or addition.

Some HELOCs may charge a small annual fee (under $100) to keep the line open but many lenders have done away with this charge. As a result, there is little downside to carrying this “insurance policy” of sorts for the future.

Once you draw on the HELOC, you will be charged interest only until repaid.

How do I qualify for a HELOC?

You qualify for a HELOC much like you do a mortgage or other types of credit, using information such as your credit score, other debt balances, and current income. As a result, it is best (and easiest) to apply for a HELOC during good times – when you have proof of income.

Keep in mind that a HELOC is a line against the equity in your home. As a result, you will need sufficient equity (ie: excess of home’s estimated fair value over other debt (if any)). Banks usually keep total indebtedness to 80% of home’s value, so depending on the price of your home and your mortgage balance, you may be limited in the available line value

What else should I keep in mind?

HELOCs can be a great tool to provide liquidity when you need it most. However, they are still debt instruments. As a result, it is wise to use them only as needed (and not as a free-for-all piggy bank). Any amount owed will be instantly due should you move or sell your home, so the bill will come due at some point.

The interest rates on HELOCs are not fixed (like mortgages) so in periods of rising rates (like we find ourselves in now), the cost to carry a balance will increase as well. However, since the HELOC is secured by your home, the rates will be far less than those on unsecured credit card lines.

In summary, HELOCs are a great insurance policy to put in place but as is true with all debt, use them with extreme caution and prudence.